Learn How to Calculate NPV (Net Present Value)
When you’re running a business it’s always important to keep a keen eye on your bottom line.
No matter what sector your business is in, profit is key. There are a number of factors that will contribute to having a positive net balance with budgeting being one of the main ones.
One of the ways that businesses can calculate their profitability is through Net Present Value or NPV.
But what exactly is NPV and how do you calculate it? We’ll show you how.
Here’s What We’ll Cover:
What Is Net Present Value? (NPV)
Net present value, or NPV, is an accounting tool that is used for potential investments. It is used to highlight the difference between the current value of cash inflows when compared to the current value of cash outflows. These are calculated over certain time periods.
NPV is used in a number of ways in the business world. For example, you would see NPV used in investment planning or even capital budgeting. It’s used in these cases to analyse the profitability of a specific project or investment.
NPV is what you get when you use calculations to find today’s value of a future stream of payments.
The way it works is if the NPV of an investment or project is positive, it means that the discounted present value, or DPV, of all of your future cash flows that are related to that particular project or investment, will be positive. This is therefore an attractive venture.
Unlike some methods, such as the internal rate of return, NPV allows investors to see which projects could create long-term value. This is rather than just identifying short-term projects that may yield a return on investments over a shorter period of time.
What Is the Net Present Value Formula?
The Net Present Value formula can be written in one of two ways:
NPV = t=1nRt(1+i) t
Rt = The net cash inflow-outflows over a single period of time
i = The discounted rate or return that could be made in alternative investments
t = Number of time periods
If you struggle with summation notation then you can also write out the Net Present Value formula like this:
NPV = TVECF - TVIC
TVECF = Today’s value of the expected cash flows
TVIC = Today’s value of invested cash
NPV In Practise
For example, let’s say that a particular project costs £1,000 and will provide three cash flows of £500, £300, and £800 over the next three years. Let’s assume that there is no salvage value at the end of this project and that the required rate of return is 8%.
The NPV of the project would be calculated as follows:
NPV = £500(1+0.08)¹+£300(1+0.08)²+£800(1+0.08)³=£1,000
What Can Net Present Value Tell You?
Using NPV helps you to account for the time value of money. It can also be used to compare similar investments if you’re looking for an alternative.
The NPV relies on a discount rate that could be derived from the cost of the capital that is required to invest. Essentially any investment or project that has a negative cash flow and NPV should be avoided.
Are There Any Drawbacks to Using Net Present Value?
One of the main disadvantages that can come about when you’re using an NPV analysis is that it looks at future events and makes assumptions. These assumptions aren’t always accurate and may not be reliable.
As gauging an investment’s profitability with NPV relies so heavily upon this assumption, there can be substantial room for error. The estimated factors include:
- Investment costs
- Discount rate
- Projected returns
As these are all estimated it leaves room for a fair margin of error. For example, a project may often end up needing a larger initial investment or unforeseen expenditures to get started. It also may need additional capital at the project’s end.
Using Net Present Value to estimate your potential investments, future cash flows and rate of return is a handy accounting tool. But as with anything that involves assumptions, it should be taken with a grain of salt as there is a certain level of risk that comes with it.
If you’re looking for more ways to keep an eye on your accounting, then accounting software such as FreshBooks is a great way to go. Try it out for free to see if it can help you and your business.
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